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Is Nintendo a Buy?

The Switch continues to be a strong seller, and the stock's valuation has gotten cheaper.

Nintendo's (NASDAQOTH:NTDOY) turnaround over the last few years has been impressive. The Switch was the best-selling game system in 2018, according to market research company NPD Group. Nintendo has already sold 163 million games for the system, and management has a strategy to keep releasing more titles for the console to grow the installed base, which reached 32 million at the end of December.

We'll review the company's recent performance, valuation, and what management has in store to grow revenue -- and whether all of it adds up to a buy signal.

Image source: Nintendo.

Recent performance and valuation

Overall, Nintendo's operating performance has been solid. Through the first three quarters of fiscal 2019 (which ends in March), total revenue increased 16% year over year to 997.3 billion yen ($9.2 billion). Nintendo sold 14.49 million units of Switch hardware for a year-over-year increase of 19.5%. However, Switch didn't sell quite enough units to meet management's ambitious goal of selling 20 million units in fiscal 2019. Management is now forecasting sales of 17 million units for Switch hardware through the fiscal year ending in March.

On the flip side, higher than expected sales of games through the holidays caused management to raise its full-year forecast for software by 10% to 110 million units. Nintendo has released several hit games to drive sales of Switch. In the first three quarters of the fiscal year, the company sold 94.6 million games, representing an increase of 101% year over year. Strong growth in software sales, which generate higher margins than hardware, drove profits up 25% year over year to 169 billion yen ($1.55 billion).

For the full year, management forecasts revenue of 1.2 trillion yen ($11 billion) and year-over-year earnings per share growth of 18%.

So, why is the stock down 31% over the last year? It currently trades for about 23 times management's earnings forecast for fiscal 2019, which is not that expensive. Media buzz and strong operating performance following the March 2017 launch of Switch drove the stock higher, as investors immediately saw the potential for the hot-selling game system to turn the company's fortunes around. However, expectations got ahead of actual results. At the beginning of calendar 2018, Nintendo stock traded for over 40 times trailing 12-month earnings, as you can see in this chart.

Expectations have come down from their previously lofty heights, and now the stock trades for a valuation that should offer investors a better return. But for the stock to move higher, the company needs to keep growing. Let's explore management's strategy to make that happen.

Games are driving sales of Switch

Most of Nintendo's revenue comes in the crucial holiday quarter, where management needed to sell about 15 million Switch units to reach its full-year goal of 20 million units. It didn't reach that goal and has revised its target to 17 million, but the company is making up its shortfall in Switch sales with the launch of Super Smash Bros. Ultimate, which proved to be a much stronger seller than anyone anticipated. The game was the No. 5 best-selling video game of 2018, according to NPD. In December, Switch generated the highest dollar sales in hardware of any game system since the Nintendo Wii in 2009. In case you're not aware, the Wii is Nintendo's all-time best-selling console, with 101.63 million units sold.

Nintendo has had a great strategy with its steady cadence of game releases to keep momentum going. Evergreen titles, which are meant to incentivize the purchase of a Switch, have remained steady in recent months, with The Legend of Zelda: Breath of the Wild, Splatoon 2, Super Mario Odyssey, and Mario Kart 8 Deluxe maintaining high attach rates with sales of Switch.

What's more, Nintendo has done a better job of winning over support from third-party game developers to put their games on Switch. This is something that the Wii U failed to accomplish -- one reason that system was a flop.

Catalysts

Long term, there are several catalysts for margin expansion and earnings growth. For one, Nintendo is continuing to build out its mobile game business, where the company has enormous potential given its classic gaming brands. Super Mario Run was released two years ago and reached 300 million downloads last year. Management is committed to releasing two to three mobile games per year. The next highly anticipated release is Mario Kart Tour, which should be a big hit given the popularity of the Mario Kart franchise.

A second catalyst is the growth of digital revenue as a percentage of total revenue. Digital sales reached a record high for Nintendo in the first half of fiscal 2019. Nintendo has also continued to release in-game updates for hit games, such as Mario Kart 8 Deluxe and Splatoon 2. A greater contribution to the top line from digitally downloaded content could spur further margin expansion and profit increases.

And Nintendo has launched its online subscription service that allows for multiplayer game play online, access to classic Nintendo games, cloud backup of game data, and other benefits for a monthly fee. It's early, so there's no telling how much revenue this will generate, but it's another pillar of management's strategy to grow revenue and earnings over the long term.

It's apparent that management is on the ball with new game releases and other initiatives to keep sales healthy for at least the next few years. Of course, the risk with Nintendo is evident in its history. The massive success of the Wii in the mid-2000s was followed by a poor reception of the Wii U, which caused a deep crater in Nintendo's annual revenue. However, that risk may gradually become irrelevant given that the industry is expected to transition to cloud gaming services down the road.

Streaming services for gaming make sense given the high capital requirements involved in manufacturing hardware and the fact that gamers are already streaming other entertainment content like music, movies, and TV shows. Other companies, such as Electronic Arts, Microsoft, and Alphabet's Google, have already announced plans to invest in cloud gaming, and Nintendo has taken baby steps in this direction with a few titles released in Japan.

Nintendo is a buy

With all these possibilities for long-term growth -- and given that Nintendo is one of the top brands in the industry -- I think the stock is a buy at 23 times expected earnings. The company also pays a forward dividend yield of 2.1%, which adds to the appeal of owning the shares. Nintendo has been around for more than 30 years, delighting gamers with its classic characters like Mario and Zelda. As its recent comeback shows, this is a gaming company I don't want to bet against.